Advisers turn to capital notes to generate more investment income for clients

There are ways to generate regular and consistent income for investors other than just fixed income and dividends.

Financial advisers and their clients continue to seek ways to obtain income in today's volatile and uncertain markets, and while there remains strong interest in fixed income and dividend income, some are identifying other specialist income generating investments.

We note, as the nation's leading wholesale trading platform, that there has been an increase in the trading of what are called capital notes on the Australian Securities Exchange (ASX).

Capital notes fall into the broad category of hybrid securities, along with convertibles and preference shares. All three have been established, and traded, for several decades.

AUSIEX sampled a large cohort of its client data, which shows hybrids recorded the highest traded value in December 2022 since at least 2018, more than double that of the value in the previous December. Trade volume amongst the adviser cohort increased 15.69% over the 2022 calendar year compared with 2021. Average trade size also increased in the order of 4.45% over the same period. The buy/sell ratio also jumped to 74.93% in December, whilst net traded value rebounded strongly from the first half of the year to end the year firmly in positive territory.

Capital notes are debt securities that have equity-like features and pay franked dividends, thus their increasing attraction to those investors who like or require income.

The fact they are issued by some of the bigger banks is also appealing to some investors who are looking for a diversification alternative to dividends.

Notes have been issued by a number of organisations in recent times including Commonwealth Bank (ASX: CBA), Macquarie Bank (ASX: MQG), ANZ Bank (ASX: ANZ), Insurance Australia Group (ASX: IAG), Westpac Banking Corporation (ASX: WBC) and National Australia Bank (ASX: NAB).

Financial advisers account for half of the demand, with much of the remainder being institutional investors.  

Across generations, for advised accounts in the cohort sampled, it was Gen X which showed a significant lift in interest, with the proportion of trades increasing from 31.12% to 37.67%, with Baby Boomers and the Interwar generation making up the balance across all trading segments (self-directed, on platform and advised). NSW accounts also made up over four in ten trades, up from just over one in three trades in 2021.

Capital notes are a type of unsecured debt a company takes to cover short-term liabilities. It is important to note that as the debt is unsecured, capital notes typically pay investors a higher interest rate – as they carry more risk than term deposits.  For example, hybrids generally rank behind other creditors if the company fails.

However, this debt is junior to secured notes, though they are monitored by the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulatory Authority (APRA).

While having the backing of well-established institutions, these investments were once considered too complex for most financial advisers’ clients. But as the market and investing has become more challenging, there has been increasing interest from a range of investors.

Investors can potentially earn more than 7 per cent paid quarterly on capital notes being offered by leading banks – more than double the returns on offer from their best-paying 12-month term deposits, noted the Australian Financial Review. But with that increased return comes potential increased risks compared to a term deposit, though comparatively less risk than bank shares.

Advisers note that capital notes are also a hedge against inflation as the yield increases as interest rates rise. But of course, seek or provide, professional financial advice with respect to investors’ individual requirements.

AUSIEX provide access for advisers to new capital notes issues and the ability to trade these instruments. To find out more about how we can support advisers with the trading of hybrids please contact your Business Development Manager or Account Manager.